Trade Creation and Trade Diversion

Statement

• Trade creation occurs when the production of a good is shifted from a country with lower comparative advantage to a country with higher comparative advantage.
• Trade diversion occurs when the production of a good is shifted from a country with higher comparative advantage to a country with lower comparative advantage.

Notes

The two are the welfare-relevant consequences of forming a free trade agreement. Removing a tariff on a member country can make a more efficient member producer cheaper than a domestic one — production moves to the lower-opportunity-cost source, raising global efficiency (trade creation). But the same tariff removal can also make a less efficient member cheaper than a more efficient non-member that still faces the tariff — production moves to the higher-opportunity-cost source, lowering global efficiency (trade diversion). The distinction turns on whether the post-agreement supplier is the world’s most efficient producer or merely the cheapest within the bloc; a single FTA can cause both for different goods. Both concepts build on comparative advantage.